Higher Risks, Lower Returns

Continuing huge inflows of capital into the world's real estate markets are increasing the riskiness of almost all property lending in relation to its yields. So many lenders are vying for real estate that intense competition also is reducing the quality of underwriting standards in all market segments. As one major lender stated at a recent conference, “Our underwriting standards haven't just deteriorated — they've plummeted!” Hence most lenders are now accepting lower returns in relation to the risks they are assuming.

This situation has two basic causes. One is that yields from alternative investments — mainly stocks (other than REIT shares), bonds, and cash — are way below those in the 1990s, and below returns from real estate. As always, the allocation of capital among asset classes is almost entirely a question of relative attraction. No matter how risky real estate deals appear in absolute terms, they seem highly attractive if their prospects look much better than the major alternatives.

Global forces at work

Stocks remain tarnished by their collapse in value from 2000 through 2002, and by continuing high levels of uncertainty in world conditions. Oil prices have recently exceeded $60 per barrel. Violence continues in Iraq, nuclear threats loom in North Korea and Iran, and Europe has been shaken by continued high unemployment and recent “no” votes on the new Euro constitution in France and the Netherlands.

As a result business firms and investors are reluctant to bet on rising stock values. Meanwhile, bond yields are at record lows. Yet rising interest rates could cause bond capital values to decline. But many investors — both individuals and pension funds and other institutions — need ongoing yields to meet their looming financial obligations. So, they turn to real estate because nothing else has recently performed as well.

The second cause is that the universe of capital suppliers interested in real estate has immensely expanded since the last period of rising riskiness at the end of the 1980s. Back then, banks and insurance companies were the main suppliers of real estate loan capital. But federal regulators, who were alarmed by savings & loan bankruptcies, shut down their lending activities and massive property defaults.

In desperation, real estate operators turned to public markets for capital, generating a proliferation of real estate investment trusts (REITs) and commercial mortgage-backed securities (CMBS). As the U.S. economy recovered, the success of these vehicles massively expanded the basic capital sources willing to consider investing in real properties, as compared to past business cycles.

The combined factors have generated an unprecedented worldwide flow of financial capital into real estate — both homes and commercial properties. But the supply of real properties in which to invest has not expanded commensurately, even though it has grown somewhat. This has driven prices upward in housing and commercial property markets throughout the developed world (except for Japan and Germany), especially where economies are experiencing at least some expansion.

Why lending risks are rising

The excessive amount of capital seeking real estate, in relation to the available supply, is reducing yields while causing lenders to relax their underwriting standards to compete. The result is a rising degree of riskiness in all forms of real estate lending. For example, the share of a typical CMBS pool consisting of the highest-risk “B piece” has become smaller as more lenders try to pick out the less risky portions of each loan pool.

In many cases, that underlying subordinated pool share — supposedly a cushion for others against defaults — has fallen from 30% two years ago to about 3% today. At the same time the fraction of many CMBS pools based on interest-only mortgages has sharply escalated to 50% or more, up from zero in 1998. And CMBS yields are lower today than they were then, in spite of the higher risks.

Even so, CMBS default rates are lower than regular corporate bond default rates. Hence investors keep pouring money into these generally more risky deals. In short, it is a great time to borrow, if you have something in which to put the money. It is also a great time to sell real properties that you do not want to retain for the long haul.

No one can reliably predict when this situation will become much less favorable for real properties. Undoubtedly, at least some of the decline in property cap rates mark a long-term paradigm shift favoring more investment in real estate. Most big investors are still playing in this game rather than running for cover and these favorable conditions may still have some time to run before hitting the wall.

But investors in the game should beware: they are now assuming more risk for less return than in the past. So, they should be sure to hold some resources in reserve somewhere.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.